Yield spread
Encyclopedia
In finance
, the yield spread is the difference between the quoted rates of return on two different investments, usually of different credit quality.
It is a compound of yield
and spread.
The "yield spread of X over Y" is simply the percentage return on investment (ROI)
from financial instrument X minus the percentage return on investment from financial instrument Y (per annum).
The yield spread is a way of comparing any two financial products. In simple terms, it is an indication of the risk premium
for investing in one investment product over another.
When spreads widen between bonds with different quality ratings it implies that the market is factoring more risk of default on lower grade bonds. For example, if a risk-free 10-year Treasury note is currently yielding 5% while junk bonds with the same duration are averaging 7%, the spread between Treasuries and junk bonds is 2%. If that spread widens to 4% (increasing the junk bond yield to 9%), the market is forecasting a greater risk of default which implies a slowing economy. A narrowing of spreads (between bonds of different risk ratings) implies that the market is factoring in less risk (due to an expanding economy).
There are several measures of yield spread, including Z-spread
and option-adjusted spread
.
The yield spread analysis also helps investors and interested people understand the market’s trend when it comes to various investment instruments. When the spread is wide between bonds of different quality ratings, the investors can conclude that the market is factoring more risk of default on the lower grade bonds, which implies that the economy is slowing down and thus, the market is predicting a greater risk of default.
On the other hand, when the spread is narrowing between different bonds of different risk ratings, the market is considered to have forecasted a lesser default risk brought about by an expanding economy. As an example, when the spread between junk bonds and Treasury notes is four percent historically, the market is generally concluded to be factoring lesser risk of default. Moreover, the yield spread analysis is also beneficial when you are a lender because it can help you determine your profitability when you provide a loan to a borrower.
As an example, when a borrower is sufficiently capable to take advantage of a loan at five percent interest rate but will actually take a loan at six percent, the difference of one percent is the yield spread, which is the additional interest that serves as additional profit for the lender. As a strategy, many lenders offer premiums to loan brokers who offer loans with yield spreads. This is to encourage brokers to search for borrowers willing to pay for the yield spreads.
Yield spread analysis assumes that there exists normal relationship between the yields for bonds in alternative sectors. The spread is seen to increase during periods of recession and decreases during periods of expansion. There are three ways by which spreads will be affected.
, a yield spread is the difference between the interest rate actually paid by the borrower on a particular loan and the (lower) interest rate that the borrower's credit would allow that borrower to pay. For example, if a borrower's credit is good enough for a lender to make a loan at 6.0%, but the borrower actually takes out a loan at 6.5%, the 0.5% difference in the interest rates is the yield spread.
As the lender earns additional interest on the loan without assuming additional risk (the borrower's credit is the same), this is a source of additional profit for the lender. In order to encourage loan brokers to find borrowers who will pay yield spreads, lenders typically offer yield spread premium
s to the brokers who bring them loans with yield spreads.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, the yield spread is the difference between the quoted rates of return on two different investments, usually of different credit quality.
It is a compound of yield
Yield (finance)
In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return...
and spread.
The "yield spread of X over Y" is simply the percentage return on investment (ROI)
Return on investment
Return on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...
from financial instrument X minus the percentage return on investment from financial instrument Y (per annum).
The yield spread is a way of comparing any two financial products. In simple terms, it is an indication of the risk premium
Risk premium
A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
for investing in one investment product over another.
When spreads widen between bonds with different quality ratings it implies that the market is factoring more risk of default on lower grade bonds. For example, if a risk-free 10-year Treasury note is currently yielding 5% while junk bonds with the same duration are averaging 7%, the spread between Treasuries and junk bonds is 2%. If that spread widens to 4% (increasing the junk bond yield to 9%), the market is forecasting a greater risk of default which implies a slowing economy. A narrowing of spreads (between bonds of different risk ratings) implies that the market is factoring in less risk (due to an expanding economy).
There are several measures of yield spread, including Z-spread
Z-Spread
The Z-spread, ZSPRD or Yield curve spread on a simple mortgage-backed security is the flat spread over the treasury yield curve required in discounting a pre-determined coupon schedule to arrive at its present market price....
and option-adjusted spread
Option-adjusted spread
Option adjusted spread is the flat spread which has to be added to the treasury yield curve in a pricing model to discount a security payment to match its market price. OAS is hence model dependent. This concept can be applied to a mortgage-backed security , option, bond and any other interest...
.
Yield Spread Analysis
Yield spread analysis is made by comparing the maturity, liquidity and creditworthiness of two instruments, or of one security to a benchmark. When referring to the “yield spread of X over Y,” it is just the percentage return on investment from one financial instrument labelled as X less the percentage return on investment from another instrument labelled as Y. In simple terms, the analysis is a method to compare any two financial vehicles for an investor to determine his options by analysing risk and return of investment.The yield spread analysis also helps investors and interested people understand the market’s trend when it comes to various investment instruments. When the spread is wide between bonds of different quality ratings, the investors can conclude that the market is factoring more risk of default on the lower grade bonds, which implies that the economy is slowing down and thus, the market is predicting a greater risk of default.
On the other hand, when the spread is narrowing between different bonds of different risk ratings, the market is considered to have forecasted a lesser default risk brought about by an expanding economy. As an example, when the spread between junk bonds and Treasury notes is four percent historically, the market is generally concluded to be factoring lesser risk of default. Moreover, the yield spread analysis is also beneficial when you are a lender because it can help you determine your profitability when you provide a loan to a borrower.
As an example, when a borrower is sufficiently capable to take advantage of a loan at five percent interest rate but will actually take a loan at six percent, the difference of one percent is the yield spread, which is the additional interest that serves as additional profit for the lender. As a strategy, many lenders offer premiums to loan brokers who offer loans with yield spreads. This is to encourage brokers to search for borrowers willing to pay for the yield spreads.
Yield spread analysis assumes that there exists normal relationship between the yields for bonds in alternative sectors. The spread is seen to increase during periods of recession and decreases during periods of expansion. There are three ways by which spreads will be affected.
- Yield volatility and the behavior of embedded options
- The effect of yield volatility on the business cycle
- Yield volatility and transaction liquidity
Consumer loans
In U.S. consumer loans, particularly home mortgagesMortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, a yield spread is the difference between the interest rate actually paid by the borrower on a particular loan and the (lower) interest rate that the borrower's credit would allow that borrower to pay. For example, if a borrower's credit is good enough for a lender to make a loan at 6.0%, but the borrower actually takes out a loan at 6.5%, the 0.5% difference in the interest rates is the yield spread.
As the lender earns additional interest on the loan without assuming additional risk (the borrower's credit is the same), this is a source of additional profit for the lender. In order to encourage loan brokers to find borrowers who will pay yield spreads, lenders typically offer yield spread premium
Yield spread premium
A yield spread premium is the money or rebate paid to a mortgage broker for giving a borrower a higher interest rate on a loan in exchange for lower up front costs, generally paid in Origination fees, Broker fees or Discount Points...
s to the brokers who bring them loans with yield spreads.
See also
- Yield spread premiumYield spread premiumA yield spread premium is the money or rebate paid to a mortgage broker for giving a borrower a higher interest rate on a loan in exchange for lower up front costs, generally paid in Origination fees, Broker fees or Discount Points...
- Yield curve spreadYield curve spread- In Economics :* Yield curve - The spread between long-term and short-term Treasuries* Z-spread - Also known as yield-spread curve, the flat spread over the treasury yield curve- In Materials Science :...
- Credit spread (bond)Credit spread (bond)The financial term, credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk...
- Z-spreadZ-SpreadThe Z-spread, ZSPRD or Yield curve spread on a simple mortgage-backed security is the flat spread over the treasury yield curve required in discounting a pre-determined coupon schedule to arrive at its present market price....
- Option-adjusted spreadOption-adjusted spreadOption adjusted spread is the flat spread which has to be added to the treasury yield curve in a pricing model to discount a security payment to match its market price. OAS is hence model dependent. This concept can be applied to a mortgage-backed security , option, bond and any other interest...